Are you taking more risk than you think?

Scott Phillips

Much of how we understand human interaction – business and otherwise – comes from the so-called "dismal science" of economics.

Our decision making – motivation, evaluation, trade-offs and rewards – is able to be observed and understood, and helps us better understand ourselves.

The problem is that where economics promised to help us with those problems, the field itself let us down until relatively recently.

Most scientists are able to objectively study cause and effect – the combination of two elements, the impact of a force on an object and so on. They can (usually) limit or eliminate the variables to isolate true cause and effect.

Economists – especially in the past – didn't have that legacy, so they made a somewhat understandable, but unfortunate decision ... to substitute assumptions for reality.

We all know what happens when you assume…

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Grand assumptions, no matter how reasonable, undermined the research and theories. Of the greatest (and most unfortunate) assumptions were the Latin phrase cetirus paribus (or, in English, "all other things being equal") and that all people were ultra-rational and always did what they objectively discerned to be in their best interest.

I don't need to tell you that all things are never equal – we can't assume the rest of the world stops when economic decisions are made. And there's enough evidence of what would be objectively known as irrational behaviour – smoking, driving too fast, paying hundreds of dollars more for the new iPhone – to put that second assumption to rest, too.

Happily, the economics profession has started to come around, and the relatively new field of "behavioural economics" is helping to redress that shortcoming.

Investing suffered a similar fate

Investing, as an academic exercise, suffered from the economists' need to be able to explain everything in a neat and complete way, too.

The concept of "efficient markets" sprung from that school of thought, where the theory held that no one could beat the market average, so it wasn't worth trying. Warren Buffett has something to say about that – both in his own words and by his very example!

From a similar place, other academics created models that somehow corrupted the concept of risk. You and I would consider "risk" to be the chances of something going wrong. The aforementioned smoking and speeding would fall into that category, as would not having insurance or tightrope walking without a net.

The theory, though, suggests that risk isn't that at all, but instead is the volatility of a share price. Yes, if a share price moves down – or up – more than the market average, apparently that's risky. I hope you'll agree that's a pretty strange definition.

Of course, that same theory has been applied to whole asset classes. So, under what is still largely accepted wisdom, investing in shares is more risky than holding cash.

"Of course it is," you say, "the company could go bankrupt or the share price could fall." Yes, investing in just one company is very risky (using the proper definition: the chance of a permanent loss) compared with a bank deposit.

The tale of the tape

But over time, and over the whole market, analysis done by Vanguard highlights the errors in that thinking. Even before last year's strong market rally, Vanguard's figures show that cash would have compounded from $10,000 to almost $134,000 in the 30 years to 2011. A nice return.

The same analysis, though, shows that Australian shares – as measured by the All Ordinaries Index – would have compounded that same $10,000 into almost $230,000. A full 71 per cent more, despite periods of high inflation, recessions, the GFC and the 1987 sharemarket crash.

Not bad for an asset class that the orthodoxy considers much "riskier".

Nothing is risk-free

Now, we do need to set some boundaries: Share prices can be – will be – volatile. No money that you need in the next three to five years should be invested in shares, simply because no one knows what the market will do in the short term.

You should be diversified. Don't expose your portfolio – and your future – to an over-reliance on one or a few companies.

No one knows what the future will bring. Enough said (but a century of returns is some pretty solid data to provide context).

You have to choose your investments well – historical performance is no excuse for poor decisions.

Foolish takeaway

Investing in shares can be a challenging pursuit if you have a nervous disposition, or an itchy trading finger. It can also genuinely risky if you don't invest well and diversify. Volatility is par for the course, but the historical returns suggest the gyrations have been worth it – as long as you have the mental discipline to approach it as a long-term strategy, and you won't need the money in the next five years or so.

With interest rates on savings on the wane, and inflation being a "silent tax" on your returns, perhaps keeping money in the bank is riskier than you'd know – and that makes shares a better option that many have thought.

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Scott Phillips is a Motley Fool (http://www.fool.com.au) investment analyst. You can follow Scott on Twitter @TMFGilla. The Motley Fool's purpose is to educate, amuse and enrich investors.

This article contains general investment advice only (under AFSL 400691).